Associates First Prepares For a Comeback

Among the most popular of specialty finance stocks after it was partially spun off from
Ford Motor
in a 1996 initial public offering, AFC stock --like the entire financial sector -- has suffered from the market's recurring worries about higher interest rates.

More importantly, though, investors have spurned Associates because of concerns about its business. First, home lending giant
Fannie Mae
may begin to encroach on Associates' biggest turf: subprime home equity loans, which account for about a third of its total receivables. (Subprime lending involves borrowers with lower credit ratings and hence, higher risk profiles.)

Also, third-quarter losses in its manufactured housing business, slowing internal growth and a modest decline in asset quality had some investors worrying that the company's stellar 20%-plus annual earnings growth over the last five years is a thing of the past.

The upshot: At 32 5/8 in late trading Wednesday, Associates' shares are off a third from their 52-week high of 49, set April 12, and are down 21% on the year.

But even as AFC stock wallows near the lows of its historical price-to-earnings (P/E) multiple range, some analysts and investors have turned more bullish.

They say the concerns are exaggerated and the stock price reflects the worst-case scenario. That gives investors a chance to buy the shares cheaply now before sentiment turns more favorable again, they say.

"The company hasn't changed its stripes," says David Berry, head of research for Keefe, Bruyette & Woods. "It's a pretty high-quality company trading at a pretty average multiple."

Berry, for one, dismisses the competitive threat from Fannie Mae as "more talk than reality." (In September, Fannie Mae announced a new program aimed at drawing more borrowers to its loan portfolio from the subprime market.)

It could take quite a while for Fannie to have any significant effect on the home equity market at all, he notes. For example, "Fannie doesn't have an origination network. That's what Associates has. There's some power to that [1,600-branch network]", he adds.

More importantly, among customers, "there's not a lot of overlap" between AFC and Fannie, adds Legg Mason Wood Walker analyst David Sochol. For example, the bulk of AFC's home equity loans would not be acceptable risks to Fannie, he says. "The concerns are more than reflected in the stock price," adds Sochol, who initiated coverage of AFC with a Buy in October.

Another big worry: losses in Associates' manufactured housing business. Because of intense competition, pricing weakened and borrowing requirements were relaxed. That was followed by defaults, a glut of repossessed homes and deteriorating asset quality.

Sochol says that AFC already has taken some "pretty serious actions" to tighten requirements in its manufactured housing underwriting, such as ending a no-down-payment program and raising prices. He expects those measures to arrest the recent decline in asset quality.

Anyway, manufactured housing is "a small part of the business and not a great user of capital," adds Jay McKelvey, an analyst at John Hancock Advisors. (Manufactured housing comprises only seven percent of Associates' managed assets.)

Right now, the stock is trading at levels last seen two years ago. AFC shares have gone from about a 10% premium to its peer group's P/E to roughly a 25% discount. The stock sells at less than half the S&P 500's multiple of next year's earnings and far below its average of 77% of the market's P/E over the last two years.

Associates First Capital shares trade at almost 14x First Call's consensus estimates of $2.39 per share next year, a 17% projected rise from estimates of $2.04 this year. It changes hands at 12x 2001 estimates of $2.78, which would be a 16% increase from 2000's earnings. The stock also sells at a nice discount to its long-term estimated annual earnings growth rate of 17%.

McKelvey, who calls AFC undervalued, says Hancock has been snapping up AFC shares during the selloff. (Hancock owned 735,160 AFC shares as of Sept. 30, 1999, according to BigDough.com .) AFC has reported 24 consecutive years of earnings growth, through other interest rate hikes and recessions as well. If it continues to meet earnings expectations, the stock could rise anywhere from 20% to 45%, to 40-50, over the next 12-18 months, the bulls suggest.

What will get it there? Lehman Brothers analyst Bruce Harting says that as the company keeps delivering 17% earnings growth, investors will eventually realize that "it doesn't get much better than that in financials." They "will come in one morning and wake up" to AFC, adds Harting, who initiated coverage of the stock two months ago with a Buy rating.

Another catalyst could come in the first half of 2000 as the company reports improved results from this year's sizable acquisition of consumer finance company Avco Financial Services.

American Express Financial Advisors analyst David Benz likes the global reach that Associated will get from Avco's 1,300 branches, two-thirds of which are outside the U.S., where growth is faster and the rate of return far higher.

Of course, if interest rates continue to move up, that would likely keep a lid on the stock. Or if the economy were to slow significantly and unemployment rise sharply, that could push the shares lower.

Right now, those scenarios don't seem likely. Instead, as AFC continues to deliver the goods, investors should reciprocate by rediscovering the stock.

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